Published February 9, 2009
Brainfood Guest-Atty.Nils P. Johnson's recent econo-thoughts :
The stock market is lower now than it was ten years ago and the economy in the worse shape since the Great Depression. This means during this miserable run all of the spew from the talking heads on financial TV, all the research papers ground out year after year by the brokerage industry and all the unending blather of our politicians and their economic advisers has amounted to less than a puff in the powder room.
I write this email in the hope it helps those of my family, friends and acquaintances who receive it to dodge at least a few of the slings and arrows of outrageous financial fortune that have been hurling at all of us since the dot-com bubble blew up eight years ago. I don’t always get the details right, but I hope you benefit from my big-picture calls, which again in 2008 were pretty close to the mark.
Let’s review how we did this last year. First of all the energy bandwagon I had encouraged you to ride for a number of years, ran out of gas in mid-year. I was then up about 8%, however, I stayed on the train too long and gave all the gains of the first six months back. I knew and had long written that if the world economy tanked, energy, in spite of worsening supply problems, could weaken. And weaken it did.
To my credit in June the Dow was at 13,000 and, starting to get my hands around the magnitude of the financial crisis, and seeing that the Chinese market diving through the floor, I urged you to hold high levels of cash, saying that I thought the Dow would dip to 10,000. Good initial call, one in which few others joined at that time.
By mid-summer I was really starting to get scared. The S&P was hanging in there around 1300 (it is now 825), the unemployment rate was 5.6% and I said this: “The correct strategy, again, is to be in Treasuries or FDIC-insured certificates of deposit and wait this out. I believe we have at least a couple of years before the economy recovers; the damage done by the implosion of financial stocks and the seizing up of our lending system is just too severe. You should not expect things to be business as usual. After the crash in 1929 things got progressively worse on Main Street for several years; it did not happen all at once. This suggests you have time to get your affairs in order. I would plan for a severe recession in which unemployment gets to eight percent at a minimum with a decent chance of us seeing ten. Get out of debt as best and as fast as you can. Pay off all credit cards. Avoid major purchases. Cash is king.” I guessed the economy would shrink at a 4% rate in the fourth quarter—it came in at down 3.8%. I opined the market would head towards 7,200 from 10,000. We got close to the seven thousand number. Give me a couple more attaboy’s…
But, I cannot tell a lie. Imperfectly heeding my own advice, I ended up down 16% in ’08, not bad compared to the broad market that dipped nearly 40%, but still down. The previous five years I had been up 25%, 55%, 45%, 5% and 16%, not a terrible record, considering the awful market. I really hope many of you have benefitted in some way from my thinking during this period, too. Again, I blow the details fairly often (and yet, if you obey my “sell any new position at a 7% loss” rule, you should not get burned too badly by the losers), but the broad view this email puts out has to been fairly correct.
Let me spend some time reflecting on how we got in this mess before I think about what the new year might look like. This is long because, hey, this is complicated. Let’s start with broad views and then focus in and see if we can come up with an investment plan for 2009. I will begin with the guts of a speech I gave in December to a western Pa.-- eastern Ohio group entitled “An Ear Full of Cider.” A little of this you have heard before.
I began the speech with a story about my favorite musical, Guys and Dolls. I’m a bit of a jazz piano player and I love the music of Frank Loesser. You will remember the set up: A famous gambler, Sky Masterson (played by Marlin Brando in the movie) has come to town and Nathan Detroit (played by Frank Sinatra), the proprietor of New York’s longest running floating craps operation knows a game with Sky in attendance is going to generate a lot of lettuce for the house.
Nathan desperately needs money so he can keep his girlfriend, Adelaid, happy. They have been going together forever and Nathan has put off marriage by constantly giving her little gifts. Now he is flat broke and she is putting the heat on to tie the knot.
The trouble is Detective Branigan has clamped down on all illegal gambling and for some time Nathan has been unable to find a place to hold his game. He is getting desperate, so he sets up a meeting with Sky at Mindy’s Deli. However, before Masterson arrives Nathan sends his cohort, Nicely Nicely into the kitchen to find out from Mindy how many pieces of apple strudel were sold the day before as against how many pieces of cheesecake. Then, Masterson shows up and the dialogue goes like this:
ND: Sky, don't think I am a pest, but do yourself a favor - eat this last little bite of cheesecake. You will thank me.
SM: Honestly, I couldn't swallow a mouthful.
ND: Still, you will admit that Mindy's cheesecake is the greatest alive.
SM: Gladly. Furthermore, I am quite partial to Mindy's cheesecake.
ND: And yet, although you might disagree, many people prefer Mindy's strudel. Do you disagree?
SM: It is my understanding that the Constitution allows everybody the free choice between cheesecake and strudel.
ND: I would be interested to hear. Offhand, would you say that Mindy sells more cheesecake or more strudel?
SM: Going strictly by my personal preference, I'd say more cheesecake than strudel.
ND: For how much?!!!
SM: - What?
ND: - For how much?!!!
SM: Why, Nathan! I never knew you to lay money on the line. You always take your bite off the top…
ND: A hundred bucks says that yesterday Mindy sold more strudel than cheesecake!
SM: - Nathan, let me tell you a story.
ND: - Have we got a bet?!
SM: On the day I left home to make my way in the world, my daddy took me to one side.
"Son," my daddy says to me, "I am sorry I am not able to bankroll you to a large start, but not having the necessary lettuce to get you rolling, instead, I'm going to stake you to some very valuable advice:
"One of these days, a guy is going to show you a brand-new deck of card on which the seal is not yet broken."
"Then this guy is going to offer to bet you that he can make the jack of spades jump out of this brand-new deck of cards and squirt cider in your ear."
"But, son, you do not accept this bet because, as sure as you stand there, you're going to wind up with an ear full of cider."
So, again, how did we end up in this mess? Otherwise stated, how did we end up with an ear full of cider? The answer: greed, the loss of corporate memory and the relaxation of social mores—all of which overcame common sense. As Americans we lived beyond our means for the better part of a generation, buying more than we comfortably could afford, saving ever less and sustained in our illusion of prosperity by a ruthless and amoral financial services industry that was abetted by weak-kneed politicians
To understand what is going on today and what will happen over the next handful of years we have to look to what has happened in the past, so let’s review a little economic history, at least the high points within the memory of some people still alive today. What we are seeing as not happened since the Great Depression and it is important to understand that era.
The stock market crashed in 1929 after a decade of prosperity in which the industrial average had increased over 500%. Then as now, leverage was excessive, with margin requirements for stock market investing at only 10%. As the decade progressed, the more the market went up, the more people borrowed, driving the market ever higher. Interest rates were kept artificially low too long and low rates meant ever more stock market leverage. Finally the bubble burst in October.
Financial panics were nothing new in the history of the United States and had occurred every ten years or so since the founding of the republic. (A good read about our financial history is John Kenneth Galbraith’s book, Money.) This one was to be a doozey because of bad policy responses, however. Although the market hit the skids in ’29, the economy did not reach its nadir until 1933 (remember that!). During that period, the prices level fell 30% in the U.S. and real economic output fell about the same amount. World trade went down over 60%. A vigorous bear market rally after the initial crash faked a lot of folks into re-entering the market too early, only to crush them as the market worked its way towards what eventually was nearly a 90% loss.
By 1930 sixty banks were failing a month. Then, inexplicably, the Fed tightened interest rates and hundreds of banks a month started to fail. Individuals lost their savings; businesses lost their ability to make payrolls and went out of business. When a bank failed in the thirties, the money supply contracted, since the bank deposits were withdrawn from circulation, there being no FDIC. Less money in circulation meant less money for businesses to borrow to support growth and the process intensified. Unemployment exceeded 25% by 1933.
With unemployment rising, tax revenues decreased, which pumped up the federal deficit. In response the Hoover administration, with the assent of the Democratic House, passed a massive tax increase to balance the budget. Marginal income tax rates were raised from 1.5% to 4% at the low end and from 25% to 63% at the top of the scale. In other words, most folks paid little or no taxes, while the high-end earners, the business owners and job creators, shouldered most of the burden. The other wrench in the gears was the passage of the Smoot-Hawley bill which imposed protectionist tariffs in an attempt to encourage internal demand. Foreign nations quickly reciprocated and international trade plummeted. All of these actions turned a nasty recession into a Depression.
The bureaucracies and make-work programs of Roosevelt Administration, contrary to popular belief, helped only marginally for on the eve of World War II the unemployment rate was 18%. As a matter of fact an article in the Wall Street Journal on Feb. 2 by Harold Cole and Lee Ohanian maintains that the reason that the economy did not recovery from the financial panic of the late twenties—as it had recovered from all the other panics since the country’s founding— was the New Deal, itself. The authors maintain that the industrial policy of the Roosevelt Administration retarded growth and recovery that otherwise would have kicked in by 1936. Few are aware that FDR had passed the National Industrial Recovery Act, which suspended anti-trust laws and allowed industries to collude and raise prices. The trade off was they were to raise wages substantially higher than going rates. This was a great deal, if you had a job, but a lousy one for the 20% who remained unemployed and would not be hired because they simply cost more than they were worth. This was the same phenomenon that kept the unemployment rate so high in Europe for the last twenty years in comparison to rates in the U.S.
A majority of economists now would probably agree that the Great Depression was cured, not by the economic policies of the New Deal, but by WWII. Pulling a couple of million men out of the labor force at a time of high unemployment and sending them overseas, along with gearing up industrial production to build the ships, tanks and equipment with which they needed to fight was, frankly, good for business.
As a consequence of the war, too, women, for the first time were welcomed into the work force in areas traditionally reserved for men, allowing the skills of half our population to be made available to grow the economy. Another factor: the G.I. Bill which allowed many of the returning soldiers to get an education, one many likely would not have received otherwise. A lot of class barriers, thus, were broken down as a result of blue collar families having men get to go to college. And so with a better-educated labor force that now included women, with our competitors in ruins, with huge demand abroad and many of our companies learning how to export, our economy did pretty well for a long time. In 1950 the unemployment rate was only a bit over five percent. The relatively good times lasted well into the sixties.
In that era it was possible for many households to exist on a single salary, that of the man. Although many more women, indeed, were in the labor force, there were still 2 ½ men for every woman. In, fact, moms were needed at home. As is often the case after a war, birthrates exploded, giving us the famous Baby Boom Generation of which many of us are members. Per capita GDP was far and away the highest in the world.
Labor unions, legitimate grievances still in their heads from the period of rough and tumble industrial relations from the seventy-five year period before the war, became aggressive, then fat and sassy. I remember a friend when we were in high school and he and a summer job, bragging about how much sleep he was able to sneak while he worked in one of the mills.
Many managements were little better, becoming complacent while our foreign competitors were saving, investing, learning from us and growing rapidly. I once saw a PBS special about how W. Edwards Deming, the U.S. industrial processes guru, came to be treated almost as a god in Japan. He was followed much more overseas than at home…
Distracted by Viet Nam and set back a notch by the inflation that flowed out of the guns and butter policy of the Great Society, we came to find that the plants and factories that rose out of the ashes of WWII in Germany and Japan were superior to our own. I recall as late as the sixties there were old steel furnaces in operation in the Youngstown, Ohio area that had been built in the 1890’s…
Though U.S. involvement in Viet Nam ended in 1973, the habits of high taxes, deficit spending and increasing government involvement in all aspects of the economy continued. By the end of the Carter administration the prime rate of interest had reached 20 percent. During this time, too, our military, after the experience of Viet Nam, had been allowed to deteriorate to the extent that when Iran took over our embassy—an act of war by anyone’s definition—we temporized, fretted and did nothing. I simplify, but this dithering attitude that was also echoed by business and labor, at a time when we were becoming less and less competitive economies overseas.
A transformation had been under way in the manner in which the Baby Boom generation viewed both government and the fundamental beliefs of our parents. We started out suspicious of authority. The experience with Viet Nam initially made us wary of government. At the same time we came to denigrate the core set of values—thrift, hard work, self-reliance and aversion to risk-- that had stood our parents’ generation in good stead. Boomers came into adulthood at a time when some comfortable assumptions, which in the main had stood our country well through the great tests of the first half of the century, were found to be imperfect. Racial injustice and sexual inequality were there for all to see and we wanted to change things. Greater attention had to be given the environment before we choked in our waste. We wanted to know when were we truly justified in launching the nation into war. The old morality seemed inadequate to address these issues.
In order to bring about great change, you have to throw it into neutral and disengage the clutch from the past. It is a hard and dangerous trick to pull off—witness the havoc wrought by Mao and Lenin. Our dilemma as young people in the sixties was that once we started questioning a handful of the fundamental belief of our parents and found them to be inadequate, we automatically assumed all of their values were suspect. But, you can’t partially rip out a tree; once you start to uproot it, death is close.
With us, government, personified by the Viet Nam war, started out as the bad guy, the establishment tool which perpetuated the inequities we perceived. Then, we slowly but surely captured it, with meager objection from the conquered institution, which now found new and greater reasons to exist. Our parents had tolerated government as the successful agent which had organized society to fight the World Wars, which attempted to lessen the pain of the Depression. At the end of the war with prosperity finally at hand, however, government’s role became greatly reduced. As the sixties moved into the seventies, however, government now came to be deployed with martial vigor in every direction, becoming the great engine to force the changes we commanded.
Government replaced individual morality. People didn’t need to fend for themselves as much; no longer did families and friends have to look out for one another; local communities and neighborhoods could abdicate their traditional roles. Welfare, roads, job training, retirement benefits, mail, cheap electricity, farm support, education scientific research… Uncle Sam would take care of all of it. Who needed the family? So families broke down. Over 70% of black children came to be born out of wedlock—contrasted with very few at the end of WWII. The overall illegitimacy rate closed in on 40%. Why get married if you fathered a child? The government would support it. Mom getting up in years, stick her in a home; Medicaid paid. The whole process produced rootlessness, a lack of social cohesion, and, I would argue, a “grab what you can, the rest of the world be damned” ethos that has recently come back to bite us hard. Instead of people solving their owns problems and helping each other, they started identifying problems to be foisted on the government to solve, problems which not only couldn’t solve, but actually made worse.
Then along came Ronald Reagan who harkened back—or at least played the role of harkening back—to earlier, more self-reliant times. Government is not the solution he said, it is the problem. His campaign team in 1980 invented the misery index which combined the inflation rate with the unemployment rate, producing a big number. In 1984 it was Morning in America. And the voters bought the can-do attitude. Paul Volker, having wrestled inflation to the ground and tax rates having been slashed from 70% to 28%, the economy prospered. Margaret Thatcher pulled off the same trick in the UK, turning a gray, sick socialist economy into one of the most dynamic in Europe.
By the early nineties voters were ready to tack to the left again, electing Bill Clinton, the first Boomer president. He started out to the left attempting to essentially nationalize healthcare and talk about gays in the military. We took a recession. Clinton, a “new Democrat,” was, in fact, a perfectly amoral man with no core beliefs, except wanting to be successful and loved. As such he easily did what he had to do to resonate with the majority of Americans who were more conservative than was his wont; he tacked to the right where the wind was be in his sails. Robert Rubin, his Treasury Secretary, managed to get capital gains taxes lowered, gently raising some taxes on high earners. With the Cold War having been successfully concluded, Clinton had the luxury of being able to slash military budgets, freeing up money to reduce the national debt. To Clinton’s credit he was smart, a fast learner, a wonderful communicator and, thereby, a successful President.
But he was an amoral man. And in this respect a tone was set and tone is important. What was the meaning of “is”? It was possible to openly and repeatedly cheat on your wife, to have sex in the oval office with an intern and lie about it. Sure, the majority of Americans did not think it important enough to remove him from office, but a tone was, indeed, set. If you could get away with it, everything was fine. You could get something for nothing; you didn’t have to worry about an ear full of cider.
This was the era of the tech boom and a continuing, Reagan inspired, entrepreneurial explosion. New technologies were flourishing; tax rates were favorable; money was free and easy and the stock market had a party. The mania that culminated in the tech market bubble and bust was classic. Most investors were swept up in it, egged on by a rapacious financial industry intent on fees and commissions. Free lunch time.
Even some of the old guard, who should have known better, became infected. I had a 93-year-old client at the time who used to work as a low-skilled worker at Youngstown Sheet and Tube. His stock broker and got him into tech stocks and he had had quite a ride, amassing over four hundred thousand. “Take it off the table,” I said, “the market’s going to blow. You’ve won; you can leave some nice money to your descendants to remember you by.” “Naw,” he said. “My broker says…” He soon lost it all and died.
And then came 9/11. In response and in order to get the economy moving again Alan Greenspan hit the monetary accelerator and kept it there much too long. But we have to back up a bit...
In 1999 Congress changed the rules and mandates for Fannie Mae and Freddie Mac, encouraging them to accept weaker borrowers into the system to foster low-income home ownership—in and of itself a laudable goal. (These were modifications to the Carter-era Community Reinvestment Act which mandated low-income lending.) As I recall, 42% of Freddie-Fannie loans were after 1999 to go to the marginal borrower. Fast forward to 2001. After the tech wreck and after 9/11 there was political pressure to re-flate fast and the Fed complied. The prime rate, which stood at 9% in 2001, was lowered to 4% by 2003. Mortgage rates came down accordingly.
Let’s rewind the clock again. When Japan crashed in the early 90’s, instead of biting the bullet and allowing its crummy financial institutions and teetering companies to fail, it patched up the institutions and let them continue to operate. Politics. This did not allow capital to devolve into the hands of the more nimble through the bankruptcy process, but left it in the hands of the old crews who had mismanaged it in the first place. (Remember this as you watch our politicians try to fix our own banking system...) The economy wallowed. To try to get things moving, the Japanese government kept dropping rates until they were essentially negative. It started building bridges to nowhere. It became possible to borrow Yen in Japan and invest the funds in the sovereign debt of countries paying much higher interest rates. It was called the carry trade.
As we got into the new decade, having survived the dot com bust, the Asian Crisis, Russian ruble crisis and S. American crises of the previous decade, things settled down.
With exchange rates apparently stable, little risk was perceived and so massive leverage was applied. This is a key point: apparent low volatility encouraged people to increase leverage mightily. And this was done across the board. An investor might borrow at 2% in Japan and invest in Icelandic bonds at 4%; and if he levered up five or ten times his ROI soared. Private equity did the same thing, buying businesses holding equity cushions, levering them way up and then taking them public to cash out. Private individuals performed essentially the same trick by agreeing to take out no-money-down mortgages. It all worked fine, as long as volatility stayed under control and there was a gentle tilt upward.
Fast forward to post 9/11 again. Between the cheap money available in Japan and the bales of the stuff being pumped out by Greenspan, the U.S. and much of the world was awash in money. Again, volatility in financial markets cash died down in the face of the flood of green.
This, then, was the set-up for the coming debacle: easy money, lax regulation, lax morals that transcended common sense, and the breath-taking greed of Wall Street. This state of affairs corresponded, not surprisingly, with the passing from the scene of those that remembered the Great Depression and the lessons that had been gleaned from that bitter experience. Go on the internet and read about Kondratiev cycles. These are 50-60 years economic cycles that the Russian economist perceived. I believe they correspond to the biological effect of inter-generational loss of memory… In any event, they left in their stead, a coddled baby-boom generation that were more than happy to push prudence to the side twice in a single decade, seduced as they were by a rapacious financial industry intent on profits and fees.
In 2004 Goldman Saks, Morgan Stanley and three other firms had the stones to approach the feds for permission to increase the leverage they were allowed to accept as investment banks from 12-1 to up to 40-1. They got what they asked for and astronomical fees began to flow. But it was a “heads I win, tails I don’t lose” arrangement. The big financial houses levered themselves up to beat the band. And, they came up with a slew of new financial products (collateralized debt obligations; alternate A mortgages, credit default swaps, etc.—see below) that nobody understood, other than they produced astounding fees. Here’s the point: because these investment banks were so integrally connected with our financial system, they were “too big to fail.” This meant that executives could push leverage and risk to the limit, taking gargantuan fees and bonuses as they went along, knowing full well the government would be forced to bail their companies out, if things went awry. In a phrase, they were playing with the house’s money. This week’s Barrons observes that in the ten-year period up to 2007 the executives at the 20 largest financial firms carved up $15.1 billion dollars in compensation.
Wall Street was abetted both by feel-good Democratic policy initiatives that pandered to their traditional constituencies and by inept Republican regulation. Although the Republicans were in charge, political pressure to allow the expansion of home ownership was intense from the Democrats. In 2003, seeing the situation getting out of control, the Bush Administration submitted legislation to rein in Fannie and Freddie. (The press conveniently forgot this.) The Republicans could not command the votes to make the change. And Barney Frank, Chris Dodd and Chuck Schumer (who, together with John Kerry and Hillary Clinton were the largest recipients of campaign contributions from Freddie and Fannie) skewered the regulators when they came before Congress to testify in favor of reform. Check out the hearing snippets on U-tube…
By 2005 the situation had reached the breaking point. The traditional relationship between the local bank with knowledge of the borrower and it’s the customer was severed. Banks became merely loan originators, flipping mortgages to Fannie and Freddie as soon as ink was dry. Mortgage originators who were not even banks, sprouted like mushrooms in the forest after a warm summer rain. Ninja loans (no income, job or assets) became de rigueur. With so many extra home seekers in the system, funded by ample dollars, home prices rose and kept rising fast. Traditionally home ownership was about 65%; this number now approached 70%. Trouble was that extra five percent simply did not have the skills necessary to sustain a job], sock a little cash away to get through hard times, and faithfully make a mortgage payment. It didn’t matter. Fees could be booked immediately when a loan was made and then the loan was flipped. In this environment many banks decided borrowers didn’t need down payments, since the downstroke/equity cushion would miraculously appear soon enough as prices rose anyway.
By 2005 it became clear the financial industry, un-sated by the carnage of the dot-com bust, was pumping up another unsustainable bubble. And this time, with the value of residences amounting to $22 trillion dollars, it was a whopper. Teaser loans, adjustable rate mortgages, home equity loans, everyone was levering up to the max. That same year John McCain submitted a second reform-of-Fannie package, but lacking 60 votes in the Senate reform again went nowhere.
By contrast the Congress of this era did see fit to aid and abet the rising insanity by passing the repeal of Glass-Steagall, the Depression-era legislation that separated commercial and merchant banking. Now your local bank was free to get into other businesses— in which it did not possess the corporate culture for success.
Amazingly, the SEC added risk and volatility to the explosive mix by revoking the uptick rule (which said a stock could only be sold short at a price above the previous trade) and made no move to enforce its rule against naked shorting. To short a stock the SEC requires that the stock first be borrowed from a third party stockholder before it can be sold. If the stock goes down, the short-seller buys the stock back and returns it to the person from whom it was borrowed. If there is no stock to borrow, there is supposed to be no short sale. The reason for the rule is to prevent powerful financial interests from collapsing stocks and disrupting markets by dumping virtually unlimited amounts of stock into a weak market. Chris Cox and the SEC, however, declined to enforce the rules against this so-called “naked” short selling.
The expanding bubble was abetted by two innovations of the financial industry which looked around for new “product” after tech imploded. The first of these involved slicing piles of sub-prime loans into slices or “tranches.” The best of the crummy loans, those with the highest, though still low, FICA scores would be given a high credit rating. Ratings agencies like Moody’s and Fitch, who received big fees for doing the ratings, were happy to oblige. Many of the first tier tranches of these so-called “collateralized debt obligations” or “CDO’s,” were given triple A ratings and sold around the world with thick prospectuses that no one could possibly understand, if they bothered to read them. Housewives in Denmark came to own this high-yielding, often levered up junk.
The second financial “breakthrough” in this period involved the creation of “credit default swaps,” or CDS’s. A smart investment banking firm (one of the “Morgans”) figured out that a bank that insured against the default of one of its loans could legally not have to count that loan against its regulatory capital. In other words by seeking a counter-party who would guaranty repayment of a loan in case the loan went down, the primary lender could effectively lever up a lot more. A parallel, unregulated banking system was, thus, created to the tune they say of $50 trillion. And it was all off the books.
And then oil prices started to rise, putting pressure on all of us, but especially the marginal borrower who was already stretched to the limit. It was the last straw… Default rates quickly ramped up and down came the giant mortgage company, Countrywide, the biggest mortgage lender of them all. It was the stone that started the avalanche...
As noted, the regulators had recently repealed a number of the very rules that had been instituted in reaction to the excesses of the financial industry in the Great Depression. Glass-Steagall was gone, as was the uptick rule. The rule against naked shorting was ignored. The financial firms that had lobbied so hard to be allowed increased leverage, the very companies that created the then innovative and now toxic financial products, started to fall one after the other. Poetic justice was, as the Great Wall Street financial houses saw one of their brethren start to stumble, they turned like a pack of wolves on their weakened comrades. No company was safe; the best of the best, Goldman Sachs, the spawning ground of Treasury Secretaries, nearly collapsed, itself.
As the investment houses such as Bear and Lehman threatened to fold, along with the giant insurance company AIG, the financial system seized up. The precise problem was that the banks did not want to lend to each other because they were painfully aware of the putrid loans they, themselves, were carrying on their own books and figured their banking buddies had done the same thing. They were right.
Compounding the mess was the fact that a couple years ago the Financial Accounting Standards Board had seen fit several years ago to pass FASB 157, which mandated that securities had to be periodically “marketed to market” as they were carried on the books of financial firms. The problem was there was no ready market for the now-smelly financial smorgasbord of sub-prime loans, collateralized debt obligations and the rest. These loans had heretofore been valued according to computer models, not based on contemporaneous trades. Now they had to be marked to market—a market that did not exist. Nobody wanted to sell a bad asset because that sale price fixed the value, the “market” price of everybody else’s shaky assets, too. By year end 2008 banking activity had nearly stopped. Lines of credit were pulled from companies with sterling credit; comptrollers despaired of keeping more than $100,000 in payroll accounts for lack of FDIC protection. Money market funds came under fire. History will probably show that the financial system came within days or hours of completely breaking down. Home prices fell 25% and the unemployment rate started to really lift off. According to NYU professor Nouriel Roubini, essentially the entire U.S. banking system has become insolvent. The rapacity and devilment of a small coterie of financial titans on Wall Street is going to wreck economies around the world and seriously deplete the wealth and savings of many.
The Congress and the President now debate how to pull out of the fire. It is not much of a debate… With the Republican wipe-out of last fall, it has become clear that the policy response is going to be much less free-market and more Keynesian/big government. There is unlimited irony here in that the proximate cause of the financial crisis was the policy of extension of loans to low-income people—a Democratic policy taken advantage of another Democratic constituency, the financial houses of Wall Street. And now the D’s are self-righteously riding to the rescue...
Sadly, the Democrats have bought themselves a powerful constituency that is going to drive the socialization of a large part of the economy for some time. And “bought” is the correct word. Obama promised during the campaign that 95% of people would get an income tax reduction, yet effectively half of people don’t pay any. The numbers are these: The bottom 50% of wage earners pay less than 3% of total income taxes. Roughly 35% of taxpayers not only pay no taxes, but actually receive money from the government in the form of the earned income tax credit. The top 5% of families (making over $153,000 a year) pay 60% of the income tax. Many of these are the business owners, the ones who create jobs. The top 1% (making over $388,000) pay 40% of the total tax. Sounds like tax “progressivity” to me. This is not broadly known by the public, which now demands through the new President that the “rich” pony up. Indeed, columnist Larry Elder reported attendees at the Democratic convention in Denver were asked what percentage of taxes the “rich” should pay. The answer? Twenty-five percent—substantially less than they already fork over.
The question is simply who should invest money, private individuals or the government? If you heavily tax the business community—and many of the people in the top brackets are Schedule C business owners—you are saying the government is best able to figure out how to spend the money and create jobs. If that idea were correct, the Soviet Union would have won…
Today we find ourselves in a situation where the government, between making actual infusions into troubled banks and car companies, and agreeing to guarantee other loans is on the hook potentially for trillions of dollars. The eight hundred billion dollar stimulus program of the House of Representative is neither timely nor temporary nor targeted as advocated by Larry Summers, Treasury Secretary. Precious few funds are allocated for infrastructure improvement which has the virtue of delivering long-term benefits. Most is pandering to traditional Democratic constituencies—which don’t pay taxes in the first place.
The government usually consumes about 20% of GDP; this has not changed for many decades. This share, however, will rise to 25% in 2009—a huge amount and the largest since WWII. And yet, we have still not dealt with the unfunded obligation of Social Security and Medicare.
So crises (often, as here, caused by the politicians themselves) beget programs and regulations that interfere with the free market. Incompetence at the political level works hand in glove with ineptitude at the business level. The worse the job done by bank, car company or airline, the bigger the bailout. If politicians screw things up with heavy taxes and regulation, they respond with more programs and more laws and heavier taxes, which makes the situation worse. Finally the whole thing blows up as the business sector which creates the jobs is crushed under the heavy hand of government. (This is exactly what is going on in Venezuela today.) Meanwhile the politicians have self-righteously claimed the moral high ground the whole way along, encouraging, as Ayn Rand said in Atlas Shrugged, the incompetent to be treated as victims while making the productive class the fall guys. Margaret Thatcher once said, “The trouble with Socialism is that you eventually run out of other people’s money.”
On the one hand the banking system must be saved; there is no functioning economy without one. The government is not is the position of being able to lease space and hire tellers and commercial loan officers and set up new lending operations around the country; the presently functioning banks are going to have to be patched together somehow. It is not an easy task. The current system drives away fresh investment because of the opacity of the books of financial institutions, who, knowing there is no functioning market for their questionable paper, keep their toxic assets hidden as best they can.
Bad loans need be stripped from banks and placed in a Resolution Trust-type entity. (The vehicle that sold off the bad loans for the government during the S&L crisis.) Judgments are going to have to be made about which loans are to be acquired, which banks are to be folded, etc; many of these judgments will be political and bad. It still has to be done. Some banks are going to have to be allowed to fail; others will have to be supported. Lots of bank shareholders are going to be wiped out—as they should be for allowing crummy boards of directors to employ crummy executives who made dumb decisions. Probably some combination of equity injections and debt guarantees will be the most effective. The point is to stop the forced sale of the mountain of questionable loans that sits out there and to at least temporarily suspend the “mark to market” requirements of FASB 157. Many of the loans will, in fact, pay off on schedule when due. Right now they are being priced as if three-quarters will default.
The above was long, I admit, but before I could take a stab at investment decisions for 2009, I needed to try to get my hands around the whole cloud… So what conclusions can we draw, if my analysis of what has happened and what is happening is even half right?
1. Massive injections of money by governments (which will be something like 15% of a country’s gross domestic product, judging by how other financial crises have been handled) will in time create massive inflation. Right now the “velocity” of money is quite small, meaning that a large amount of green in the system is not igniting a conflagration because economic activity is so depressed and money is not circulating very fast. As soon as things improve, this will change. The rise in public debt caused by the bailout will be dramatic. Politicians easily spend other people’s money and will overshoot. To induce the Chinese and everyone else to purchase this huge pile of paper will require much higher interest rates eventually. Therefore, avoid all middle and long-term debt. As the coupon rises, the principal of a debt instrument decreases. Keep your cash in short-term Treasury funds; avoid money market funds, which are not safe. Forget trying to make money in this environment; preserve capital.
2. Even though we are currently experiencing deflation—which stands to get worse—gold will continue to do relatively well as a substitute currency. Eventually it will do well as an inflation hedge, too. The Smoot-Hawley tariffs made worse the Great Depression, everyone agrees. Nobody is going to re-vamp them, right? Wrong, except it will be done in a back-handed way. The same thing can be achieved by: a) competitive currency devaluations and b) “buy American” (buy French, buy Lithuanian…) policies connected with national stimulus packages. (See the current provision in the House bill.) The politicians around the world cannot help themselves… Currently, there is a currency race to the bottom as countries deficit-spend and drop rates in an attempt to re-flate. The dollar has big problems, but which currency is better? The Deutschmark is subsumed in the Euro. No safe-haven there. The Germans are forced to snuggle up with shaky Ireland, Spain, Greece, Italy, the Balkans, and much of eastern Europe. Thus, the Euro is a limper currency than the greenback. If you had to pick one currency, it would be the yen. After struggling to recover from their bust fifteen years ago, they were too broke to buy into Alt A mortgages—and yet they are once again in recession. China scares me; if it blows up, God help us… Gold, the supply of which is not easily increased, has, as a consequence, been a store of value for thousands of years. Even without inflation, it has the prospect of hitting $1,500 within, say, three years. Silver is an industrial metal, industry is depressed and it may end up doing less well. I would take a month or two and dollar-cost-average 20% of my portfolio into gold. Keep the rest in cash.
3. Energy is going to struggle for two or three years, but will emerge as a top asset class as soon as the world starts to take a few timid steps towards recovery. Crude liquids production likely topped out in 2005. The current drop in demand will amount to 3-5 million barrels a day as the depression works its way along. The fly in the ointment is that, soft economy or not, depletion of the world’s giant oilfields is inexorable. The biggest field in Mexico, Cantarel, is collapsing. Within five years Mexico will be a net importer. Russia is hostile to foreign investment and, thus, it is no surprise their production has just rolled over. The great fields in Saudi Arabia are fifty years old and dying. The North Sea rolled over years ago, as did Burgen in Kuwait—you get the idea. All of the “green” solutions are fiddling with the problem around the edges, as President Obama will learn. When the world revives and hits the accelerator in 2-3 years, the car is going to sputter and oil will hit new highs. Because of current low energy prices, drilling budgets are being drastically cut back; tar sands operations in Canada are being curtailed. But, guess what? After the tech and real estate busts, the next big “product” to be offered by Wall Street will be energy. Three or four years ago I wrote that the then shares of the S&P 500 held respectively by financials and. energy (30% vs. 15%) would reverse and it’s happening. I think I read recently that financials have sunk to 10%; soon enough energy’s share will rise a bunch...
4. Stay the hell away from investments in any financial company. You can’t do the calculus; you can’t figure out what these guys are storing in the cellar. And note this: if you are carrying any whole life insurance policies, be careful. A number of them have toxic assets on the books. As a matter of fact, I would be very tempted to borrow out most of the cash value of any policy of which you are not 100% sure of their books. Little has been written about this, but beware.
5. We are going through a multi-year process of draining leverage from the system. Less leverage—to say nothing about higher inflation—is going to mean much lower price earnings ratios. Forget about 15-20. Again, if the S&P earns $50 this year (and it is looking to be less…), then a 12 PE ratio gives one 600 on the S&P, which currently is 830. It may turn out that a 10 PE is more realistic… To heal the system is going to take time; be patient, this is probably a 12-year-plus process starting with the dot-come bust in 2001. Look, the way to swell your savings account these days is not to make returns on investments; you must—save more.
6. History suggests that wicked bear markets deliver plenty of sharp, head-fake bear market rallies. Are you a good trader? Then, maybe you want to play these. (Better man than I am…) We probably have a feel-good Obama rally coming up after the President gets his stimulus package passed. After a couple of months it will fade. Don’t get sucked in; study the charts of the U.S. from the thirties and Japan since its crash in the early ‘90’s. Again, it takes time to heal. Preserve capital.
7. We will experience some sort of “depression” and not a mere recession; it is going to be bad and the unemployment rate is going to get much worse than the commentators are currently prognosticating. Last summer I figured we would reach 8-10 percent. However, I do not like the Obama approach and I think we may hit 10-12%. He is going to make it worse. My wife yells at me all the time for being so “gloomy.” It ain’t gloomy; it’s just trying to make some cool-headed conclusions from the data. We have not seen data like this in our lifetimes.
8. Obama will stub his toe hard in the early going as Clinton did. Then, he will tack to the middle because he is a smart s.o.b. and, he will do better. Hopefully, he will come to understand Afghanistan is a pile of rocks and that Bush’s hard-won success in Iraq is profound in an era of decreasing oil supplies.
9. Home prices in the formerly hottest markets will fall another 15-20%. Refinance, if you can get a rate under 5%.
10. The global warming hysteria will start to die down as people start to realize that a) it’s a bunch of bulls---t and 2) they don’t want to pay for its remediation, even if there is something to it. The crest of the mania will be seen to be Al Gore’s Nobel Prize.
11. Pray that Obama uses the current financial crisis to deal with Social Security and Medicare. It’s the best chance any politician has had. Fact is we all are going to have to work a couple of years longer before drawing down on the system. There is no other way for the system to remain solvent. The Pres should use the crisis to ask for shared sacrifice and deal with this now. If he does so, foreigners will be much more likely to support our debt without driving up interest rates.
12. People are going to figure out what is important. I took a walk through the mall in Denver while I was working here this week. I ran into a kiosk called the “Hermit Hut.” They were selling psychedelic snail shells containing hermit crabs. Every family must own one… You should take a walk through your own local mall. Take a look around. How much of the stuff that is being hawked do you really need? Truth to be told—probably not much. Folks are going to be forced to figure out what is important and make choices. And you know, it’s not a bad thing. Much of what has colored life in our consumer society in the U.S. the last few decades is puff. Family is important; friends are important; integrity is important; helping others is, too. Stuff is not. Sex in the White House is not… My father always said, “What this country needs is a good Depression.” I never understood that until recently. The Greatest Generation understood what is important…
13. The U.S. will emerge from all the carnage of these years in relatively good competitive shape. Joseph Schumpeter’s “creative destruction” will have had its normal cleansing effect. Yes, after all the doom and gloom set forth above, after all the challenges, the fact remains that the structure of our society dictates we have massive competitive advantages. They are contained in our system of rule of law, in the decency of our people, in our work ethic and in our profound cultural ability to adapt to change. These are not small things. They are the essence of real wealth.
Have a tolerably good 2009.
-- Nils Johnson